Wednesday, June 12, 2013

Declining volatility in crude oil - is it all about to change?

Since posting this chart of WTI crude oil price (sent by a reader) on Twitter, we've received a number of constructive replies. The technical trading term for this pattern is "symmetric triangle", which would typically result in a breakout to either side. Usually such breakouts are accompanied by rising volatility.

Here are some replies (thanks!):

One thing that is certain about the chart is that crude oil volatility has been declining since the financial crisis. Here are three measures that prove it.

1. Crude oil implied volatility is hovering around at least a decade low.

Source: DB

2. The same applies to historical volatility (as to be expected).

3. The CBOE Crude Oil Volatility Index, which is derived from the implied volatility of oil ETFs, paints a similar picture.

Source: CBOE

Now that we've established this fact, what are some of the fundamental reasons for this decline? One of the more credible explanations is the recent diversification of supply sources from the rise of non-OPEC producers, particularly in North America. These new sources of crude reduce the potential impact of any single supply disruption.

Another explanation for declining volatility is a much more modest and a somewhat more predictable global demand growth. This is to a large extent the result of China ending the global commodities "super-cycle" (see discussion here and here). In fact we saw some evidence for this trend today:
Reuters: - The International Energy Agency (IEA) said modest economic growth was limiting oil demand worldwide, and that some developed economies would see absolute declines in oil consumption in 2013.

In China, the world's No. 2 oil consumer, "weaker economic growth and lower than previously forecast March/April consumption data" support the view that demand is weakening, the IEA said.

Both OPEC and the U.S. Energy Information Administration (EIA) cut their global oil demand growth forecasts on Tuesday.
The fundamentals therefore argue for some permanency to this low volatility regime - especially a lower risk of a major spike in prices. From the technical perspective however, we are about to enter the "tip" of the multi-year symmetric triangle and should expect the pattern to break toward higher volatility.

We should know who is right fairly soon.
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